In the world of investing, benchmarking is everything. Analysts and investors need a sense of the average to evaluate if certain metrics fall above or below it. Unfortunately, identifying an accurate average is more difficult than it seems. This is especially true when determining a company’s price-per-earnings ratio. The ratio itself is easy enough to calculate. However, the answer you get might not always represent the reality of the situation. This is why many long-term investors use the CAPE ratio instead.
Also known as the Shiller P/E ratio, the CAPE ratio takes a slightly different approach to calculating the earnings-per-share of a market or an individual stock. It doesn’t use static data points to calculate the company’s relative value. In fact, it uses an aggregate value based on the company’s historical performance.
Here’s a closer look at the CAPE ratio: how it works, how to calculate it and why many analysts rely on it as a more accurate benchmark for market and stock values.
The Problem with the Regular P/E Ratio
To understand why financial analysts use the Shiller P/E ratio, it’s important to look at the shortcomings of the regular price-to-earnings (P/E) ratio. As a quick refresher, you can calculate P/E by dividing share price by earnings per share (EPS). For instance, if the share price is $10 and the EPS is $1, the P/E is 10.
The chief problem with a standard P/E calculation is that it doesn’t account for the economic cycle. This is because it relies on the current share price. And P/E only offers a snapshot into the forward-looking financial health of the company. As a result, it might misrepresent the value of the company. If EPS rises or falls while the stock’s price remains the same, it’s more of an economic indicator as opposed to a barometer for company performance.
To get a true picture of the P/E of a company, investors need to consider the entire economic cycle. That means relying on a metric like the CAPE ratio. It uses an aggregate average for earnings-per-share.
The CAPE Ratio Formula
The CAPE ratio differs from the regular P/E ratio in that it uses adjusted EPS. Specifically, you’d take the 10-year average EPS (adjusted for inflation) and subtract adjusted earnings. This gives you an average EPS. Then, the formula functions the same, dividing current share price by this aggregated EPS figure. The formula looks like this:
CAPE Ratio = Share Price / (10-Year Average EPS, Inflation – Adjusted Earnings)
In taking a decade’s worth of EPS data and adjusting for inflation and earnings, the new EPS reflects the entirety of the economic cycle. It measures the company’s performance over a longer time horizon, to better-account for highs and lows in its performance. Investors walk away with a clearer depiction of the P/E ratio, and a more realistic benchmark for valuing a stock.
History of the CAPE Ratio
The problem of using static figures in pursuit of dynamic insights about a stock is one famed investor Benjamin Graham discussed at length in his 1934 book, Security Analysis. He posited that using averages was a better way of calculating financial ratios. But it wasn’t until 1996 that Yale University professor Robert Shiller and his colleague John Campbell proposed the CAPE ratio.
Shiller and Campbell expounded on Benjamin Graham’s aggregate average concept with a practical method of calculating earnings-per-share over the course of an entire economic cycle. Together, the two published a book called Valuation Ratios and the Long-Run Stock Market Outlook. This text not only outlined the CAPE ratio, it also provided applied examples of the ratio for S&P 500 earnings going back to 1872.
While many financial analysts lauded the creation of the Shiller P/E ratio, it gained even more notoriety when it correlated with both the Dot-Com Bubble and the Great Recession. While it’s far from a crystal ball, the CAPE ratio is nonetheless a proven tool in benchmarking the financial health of companies and markets.
Drawbacks of the CAPE Ratio
While it can be an improvement over the traditional P/E ratio, the Shiller P/E ratio does have a few notable drawbacks.
The most glaring shortcoming of this ratio is that it’s backward-looking, not forward-looking. This can skew outcomes when looking at growth stocks and fast-moving upstarts. For instance, a company might have a sizeable CAPE ratio during the 10-year run-up to market domination. However, this aggregated EPS might not represent a realistic expectation for the company’s future short-term outlook as it plateaus.
Calculating the Shiller P/E ratio can also be a minefield, since Generally Accepted Accounting Principles (GAAP) have a tendency to change over time. As GAAP rules change, so do the factors that account for a company’s earnings. Going back 10 years to gather EPS and adjusted earnings may skew the ratio. Again, this is the problem with a backward-looking metric used for current and forward-looking purposes.
Finally, using the CAPE ratio as a broad-market benchmarking tool can result in inaccuracies due to mega-cap companies. In cap-weighted indices, significant movement at the top can skew any P/E metric. This especially becomes a problem when using 10-year data.
Benchmarking the True Value of a Company
For long-term investors, one of the most important benchmarks to consider is the value of a company vs. what it’s trading for. Many investors use P/E as a quick metric for understanding relative value; however, the CAPE ratio might be a more accurate way to gauge whether a stock is over- or under-valued. And while looking back isn’t always the best solution for making forward-looking predictions, the CAPE ratio provides aggregate data that’s an effective means to benchmarking a company’s value.
